Wallison Reinvents History – and His Own Positions on the Causes of the Crisis

By William K. Black

(Cross-posted with Benzinga)

If capital costs are low, more capital will be available for companies that need it, capital will be allocated more efficiently, we will have faster and broader-based economic growth, and the welfare of all Americans will be enhanced.

The Federal Reserve is in the process of drafting detailed regulations dealing with alleged problems of so-called “predatory lending” in the subprime mortgage market, and the Congress is considering actions to curb various alleged abuses in this type of lending.

Because much of what is classified as predatory lending involves loans to low-income, minority, and higher-risk borrowers, a central principle that should guide legislation and regulation in this area is the desirability of preserving access to subprime mortgage credit for such borrowers, who are most at risk of losing access to this market in the wake of misguided and punitive regulations. The democratization of consumer finance that has occurred over the past decade has created new opportunities for low-income consumers. This is now threatened by chilling effects that inappropriate regulations and laws might have on the supply of subprime credit to these consumers.

Subprime credit to low-income consumers necessarily entails higher interest rates. As recent evidence of increasing loan defaults demonstrates, this line of business is risky, and institutions will only be willing to provide such credit if interest rates are sufficiently high relative to risks and other costs of servicing consumers. One of the risks that must be borne by intermediaries is regulatory risk. Laws or regulations that place lenders at greater risk of legal liability for having entered into a loan agreement (for example, state and municipal statutes that penalize refinancings that could be deemed contrary to the interests of the borrower) generally will reduce the supply of beneficial lending as well as predatory lending. Illegal lending, however, would not be reduced; indeed, it would be encouraged.

The GSE form–at least as it is embodied in Fannie Mae and Freddie Mac–contains an inherent contradiction. It is a shareholder-owned company, with the fiduciary obligation to maximize profits, and a government-chartered and empowered agency with a public mission. It should be obvious that it cannot achieve both objectives. If it maximizes profits, it will fail to perform its government mission to its full potential. If it performs its government mission fully, it will fail to maximize profits.

[T]he incentives of their managements [are] to increase their own compensation.

This has direct consequences in the real world. Since 1992, Fannie and Freddie have had an obligation to assist in financing affordable and low income housing. Obviously, doing so would be costly, and would thus reduce their profitability. Studies now show that their performance in financing low income housing—especially in minority areas—is far worse than that of ordinary banks. In other words, despite the fact that Fannie and Freddie receive subsidies to perform a government mission—in this case support of low income housing—their need for and incentives to retain a high level of profitability is an obstacle to their performance.

Other GSEs–and here I am thinking specifically of Fannie Mae and Freddie Mac–while they hold a government charter, are much closer to the business corporation model. They have actual shareholders, are listed on a securities exchange, and in terms of the way they present themselves to the financial markets are profit-maximizing entities. Although five of their directors are appointed by the president, I am told that these directors are advised by counsel for Fannie and Freddie that their duty of loyalty runs to the corporation and its shareholders and not to any stakeholder or any government mission.

[T]he subsidy realized by Fannie and Freddie is the worst kind of corporate welfare–a transfer of wealth from the taxpayers to both the generally well off (Fannie and Freddie’s investors) and the genuinely wealthy (Fannie and Freddie’s managements).

We understand from the rules of corporate governance that the directors of corporations like Fannie Mae and Freddie Mac are expected to serve the interests of the corporation and the shareholders by seeing to the maximization of profits. The fact that they have a government mission is irrelevant–as is, we are told, the fact that some of them are appointed by the president. So, in a quite literal sense the directors of Fannie and Freddie face a conflict between the government mission of their corporations and their duty to maximize profits for shareholders. Any claim that they are discharging a public trust is an illusion. To the degree that they do anything less than maximizing profits it is to maintain their valuable franchise by reducing their political risk, not because they are voluntarily fulfilling some public trust. It can’t be otherwise; they are legally bound to a duty only to the corporation and its shareholders.

This is very clearly seen in Fannie and Freddie’s activities in affordable and minority housing. Study after study has shown that they are doing less for those who are underserved in the housing market than banks and thrifts. Not only do they buy fewer mortgages than are originated in minority communities, the ones they buy tend to be seasoned and thus less risky. Despite Fannie’s claims about trillion dollar commitments, they are meeting their affordable and minority housing obligations by slipping through loopholes in the loosely written and enforced HUD regulations in this area.

In other words, two companies that are immensely profitable and claim to have a government mission, are doing as little as they can get away with for those who most need assistance–while swamping the airwaves with advertising that they are putting people in homes. This should be no surprise, since their incentives push them in this direction. As shareholder-owned companies, they are maximizing their profits–as they must–while doing just enough to avoid the criticism that might result in the loss of the government support that enables them to earn these profits.

Fannie and Freddie suggest that they provide special assistance to minority families hoping to become homeowners. And if they did this disproportionately–that is, helped minorities or low income borrowers more than they helped middle class borrowers–that would be a powerful argument for preserving their current status.

But they do not do this. Instead, according to a study by Jonathan Brown of Essential Information, a Nader-related group, Fannie and Freddie buy proportionately fewer conventional conforming loans that banks make in minority areas than they buy in middle class white areas. Other studies have shown that the automated underwriting systems that Fannie and Freddie use to select the mortgages they will buy approve fewer minority homebuyers than similar automated underwriting systems used by mortgage insurers.

The sad fact is that Fannie and Freddie–two government sponsored enterprises that have a government housing-related mission–do less for minority housing than ordinary commercial banks. Studies have repeatedly shown that banks and other loan originators make more loans to minority borrowers than Fannie and Freddie will buy. That in itself should be a scandal, together with the fact that both companies seek through their soft-focus advertising to create the impression that they are actually using their government benefits for the disadvantaged in our society.

In recent years, study after study has shown that Fannie Mae and Freddie Mac are failing to do even as much as banks and S&Ls in providing financing for affordable housing, including minority and low income housing. After studying the issue for years, HUD has finally proposed regulations that would tighten the definitions of such terms as “low and moderate income,” “underserved areas,” and “very low income families.” Then HUD set a goal that required Fannie and Freddie to devote increasing percentages of their total business to assisting families in the affected groups to become home owners.

In the regulations we will be considering in this conference, HUD is making a valiant effort to bring the activities of Fannie and Freddie into alignment with their statutory mission and with their advertising claims..

Now, I want to be clear about what the problem is. In reality, Fannie and Freddie are not charged by statute with responsibility for increasing minority housing

[I]t is doubtful that any set of regulations and any enforcement would be successful in driving these companies in a direction they do not want to go. That is the subtext of the discussion today.

These are two very different ways of performing their functions, and have very different consequences. When Fannie and Freddie create pools of mortgages and sell MBS backed by these pools, they are guaranteeing that investors will receive a stream of revenue derived from the interest and principal paid into the pools by homeowners paying off their mortgages. In this case, Fannie and Freddie are taking only credit risk–the risk that homeowners will not meet their mortgage obligations. This is not a very significant risk, especially today, when losses on mortgage pools have been running at 1 or 2 basis points.

However, buying and holding mortgages or MBS is an entirely different story. In that case, Fannie and Freddie must take interest rate risk in addition to credit risk. Interest rate risk–that rates will rise or fall–is a far greater risk than credit risk, and requires Fannie and Freddie to buy derivatives of various kinds to protect themselves against the vicissitudes of the credit markets. To put this in perspective, it was interest rate risk that caused the failure of the S&Ls.

We’ve had a terrible scandal on Wall Street. What is your view?

Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.

It is important to recognize the significance of the accounting problems at Freddie Mac–not because these problems are especially severe, but because they were a surprise and seem to arise from something so routine. From press accounts, it appears that Freddie attempted over many years to manage its earnings by manipulating the valuation of its derivatives. This is known as managing earnings, and its objective is to create a smooth upward curve. Freddie Mac was so good at this that it was nicknamed “Steady Freddie” on the Street. Some attention is now also being paid to Fannie Mae’s financial reports, which, despite the vicissitudes of the mortgage market, interest rates and the economy generally, also showed the same smooth upward curve. Managing earnings is very easy to do under Generally Accepted Accounting Principles (GAAP)–so easy that many companies are suspected of doing it.

The fact is that GAAP financials are highly malleable, and should not be considered an index of the financial condition or prospects of companies. Because the principal constituents of a GAAP earnings statement are predictions about the future–what losses will be suffered on a portfolio of receivables, what reserves should be established for future claims–bottom line financial results reflect simply the judgments of management rather than a true picture of the company’s financial condition.

Because of the uncertainties associated with GAAP, it is not correct to believe that Fannie Mae and Freddie Mac are financially strong companies simply because they are producing earnings or have strong-looking balance sheets. It’s likely that they are both profitable and financially strong, but we really can’t know for sure. A demonstration of this is the fact that OFHEO–Fannie and Freddie’s regulator–was not aware of the true extent of the company’s financial problems until advised of them one day before they were announced. If their regulator could not find their financial problems, how is the general public–or Congress–supposed to do it?

But in relying on regulation we are again deluding ourselves. Occasionally, regulators stumble upon things like bad accounting, but in most cases they are in the dark until someone tells them about the problem. Thus, I don’t blame OFHEO, or believe that it is a weak or incompetent regulator because it failed to uncover or understand the gravity of the accounting problems at Freddie. This is what we should expect from any regulator, because it is the most likely outcome. Regulators work in the bowels of the organizations they regulate, but the big decisions–the ones that can really cause the losses at a company–are made at the top level, where regulators generally have no regular access.

Until June of this year, when Freddie Mac dismissed its top three officers and announced that it would have to do a considerably bigger financial cleanup than we initially thought necessary, it was possible to say that both Fannie and Freddie were in strong financial condition and that there was no prospect of a bailout. Since then, however, there has been much more scrutiny of the financial statements of both companies, and at least some observers have pointed out that while Freddie might have been more profitable than it reported during the three years ending in 2002, Fannie Mae might actually have lost money, or made no profits, last year. That is not what Fannie reported, which was of course another huge annual increase in profitability. The problem is, because of the malleable nature of Generally Accepted Accounting Principles (GAAP), we don’t really know how these complicated companies are doing.

[T]he Enron collapse called into question the most fundamental beliefs of investors in the United States about how their interests were protected. It is important to keep in mind that investors in public companies have relatively little control over how their funds are used by the company’s management. Investors’ willingness to purchase equity shares depends on a belief that management will hold to explicit or implicit promises about how the company will be operated, and in the most general sense this promise is that the company will be operated for the benefit of the shareholders and not the management. To assure that management is observing this commitment, investors rely on several “gatekeepers” or monitors–a belief in the efficacy of corporate governance, in the diligence and honesty of accountants, in the quality of Generally Accepted Accounting Principles (GAAP) as in force in the United States, and in the expertise of securities analysts at the major brokerage firms.

All these monitors failed in this case, and failed spectacularly.

Under these circumstances, when the management of an issuer engages in fraudulent or manipulative practices in connection with the company’s disclosures of financial information, and these practices are not caught by the board of directors, by the accountants or by the analysts, there are essentially no safeguards for investors. Since this is what happened in Enron, where a high quality board, a major accounting firm, and virtually all sell-side securities analysts failed entirely to understand or stop a management fraud that was going on right in front of them, it is no wonder that US investors are nervous about whether the safeguards they have been relying on are truly useful. That, in my view, is the true significance of Enron, and accounts for the extraordinary attention this particular fraud has received.

By now every one of you must have 6.46 [the earnings per share bonus target] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank [Raines], we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%. Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals [emphasis in original]. (Office of Federal Housing Enterprise Oversight, 2006, p. 4)

GAAP and all other methods of financial reporting, including International Accounting Standards, are inherently malleable, and results can be easily adjusted by corporate managements to meet predetermined targets. It is possible, perfectly legally and within the rules of GAAP, to produce audited income statements showing results that are highly variable simply by changing predictions about the future–for example, by increasing or decreasing reserves, or depreciation rates.

During that period, the earnings of public companies grew steadily from year to year, frequently hitting to the penny the forecast for quarterly earnings per share made by the sell-side analysts.

This was possible because, wholly legally, companies could hit earnings targets by adjusting one or more of the variable elements involved in the preparation of financial statements under GAAP. This gave rise to claims that companies were engaged in “earnings management,” but to no effective cure. In fact, what seems to have been occurring was a game in which analysts and investors were testing the quality of a company’s stated earnings by determining whether management could hit its targets. If it could, that meant that the company’s earnings were probably growing, although not necessarily as stated. If it could not, that was a signal that the company had run out of ways of adjusting its results to produce earnings growth, and that in turn suggested that its earnings had really fallen quite dramatically. It was because of this that we saw the strange market phenomenon in which companies that missed their earnings targets by a penny or two saw 20 or 30 percent declines in their share prices.

Since there is no “correct” statement of income, and corporate managements were and are in a position to show earnings results within a broad range, smoothing earnings so that they grow gradually over time is not necessarily dishonest, and it is certainly rational. The problem then is not dishonest managements–although there are some–it is excessive reliance on a financial disclosure mechanism–Generally Accepted Accounting Principles–that inherently permits a variety of outcomes.